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In March 2000, California state Treasurer Philip Angelides announced a bold new initiative. Angelides felt the Golden State could do good for both the citizens of the world and its retirees by taking state pension fund money out of two asset classes that were performing horribly at the time, tobacco stocks and emerging markets, and reinvesting in something with a social benefit — businesses and real estate in low-income neighborhoods in his home state. Angelides called the initiative the "Double Bottom Line," because it would produce both a social return and strong investment results.

Eight years later, Angelides is gone, but the state's two big pension funds are still wrestling with the fallout of the initiative. A recent report from the California State Teachers' Retirement System (CalSTRS), revealed that the $170 billion fund, the nation's third-largest, would have been $1 billion richer if it had stayed in tobacco stocks. Meanwhile, investments in California real estate are proving particularly painful for the nation's largest fund, the $230 billion California Public Employees' Retirement System (CalPERS). Among other bad deals, it faces a loss of nearly $1 billion on one land investment alone.

The performance of the Double Bottom Line plan illustrates the potential drawbacks of socially responsible investing. While it's fine for individual investors to vote their conscience by putting money into the growing number of socially responsible mutual funds, they should know that it could lead to weaker investment performance. Although the most closely watched index of socially responsible companies, the Domini 400, has slightly outperformed the S&P 500 since its inception in 1990, it has underperformed in the past 10-, 5-, and 1-year time periods. Like it or not, people do gamble, smoke, and buy expensive nuclear-powered war machines.

Consequences take years to show upThe Double Bottom Line saga also provides a cautionary tale for all public funds that let investment decisions be made by politicians, rather than by the investment professionals hired to do so in the first place. Politicians on the campaign trail can generate fast headlines by announcing bold investment initiatives, but the bottom-line consequences of such actions take years to show up. Angelides has since left public office, having lost his bid to replace Arnold Schwarzenegger as California's governor in 2006.

A spokesman for the former treasurer notes that many CalPERS investments in California real estate "either predated his involvement, occurred after he left, were decided upon by staff or were unrelated to Phil's policy initiatives." In an e-mail response to BusinessWeek.com, Angelides said: "I am extraordinarily proud that during my tenure as State Treasurer, California's pension funds set new standards for responsible investing, posted record returns and boosted pension fund assets from $244 billion to $386 billion. I am particularly proud of our successful efforts to invest in urban, inner-city neighborhoods, where CalPERS has earned annual returns of more than 20% while creating jobs and hope in communities too often left behind."

The first part of the Double Bottom Line to unravel was the push to reduce investments in emerging markets. Angelides proposed, and CalPERS approved, a method for screening foreign countries based on such criteria as whether they had a free press and laws in place to protect workers. The program was a diplomatic disaster for CalPERS after countries such as Indonesia, Malaysia, the Philippines and Thailand got dropped from the list of approved investments.

Excluding some angry countries
The Thai stock market fell 7 percent in just two days after the list came out. Representatives of the dropped countries howled and bused local citizens to CalPERS' Sacramento headquarters to protest. It proved particularly embarrassing when the data used to exclude the Philippines turned out to be old and the country was reinstated.

An even bigger problem was that CalPERS was excluded from investing in such economic powerhouses as China, India and Russia. A 2007 CalPERS report found that the fund's emerging-market investments underperformed an index without the same screening process by 2.6 percent a year, costing the fund some $400 million in lost gains. In August of last year, the fund changed its policy after declaring victory over the social ills it had targeted.

"Year by year, scores are improving, and many countries have responded to our standards for investing," Rob Feckner, president of the CalPERS board, said in a press release announcing that the fund had repealed the screening policy.

Can't quit smoking
Next to be reinstated may be tobacco. In a June 4 report, CalSTRS revealed that excluding tobacco stocks had cost the fund more than $1 billion in lost gains over seven years. After all, shares of tobacco giants Altria (MO) and Reynolds American (RAI) had shot up threefold and sixfold, respectively, this decade. The CalSTRS staff found that the potential costs of lawsuits and increased regulation of tobacco companies were no longer as dire as they were and that a movement among state pension funds to divest themselves of tobacco stocks had waned. The report said the fund "could no longer justify" excluding the stocks on a financial basis and recommended repealing the policy.

In general the professional money managers who run the California pension funds have opposed restrictions on what they can invest in. Exiting an asset class typically costs the funds millions of dollars in transaction fees, capital gains taxes, and fees to consultants to both justify the divestiture and monitor the ongoing performance. The CalSTRS board is expected to consider reinvesting in tobacco stocks at a meeting in September.

Then there's real estate. Based to a large degree on the Angelides push, CalPERS and CalSTRS invested heavily in real estate in their home state. One big beneficiary was Victor MacFarlane, a San Francisco money manager who invested CalPERS money in low income urban areas in partnership with basketball great Earvin "Magic" Johnson starting in 1996.

At a conference on California investing co-sponsored by CalPERS and CalSTRS last September, MacFarlane noted that the definition of urban investing had since expanded to include not just investments in poor neighborhoods but luxury high-rise condos and suburban master-planned communities. He said he had earned CalPERS returns of 33 percent a year. "The bottom line — or the double bottom line — is that urban real estate investments can help revitalize downtrodden neighborhoods and spur economic growth," MacFarlane said. "Pension funds and others are proving you can do well by doing good."

Real estate headaches
But much has happened in California real estate markets just since last September, as home sales and prices have plummeted. In February of last year, MacFarlane directed $970 million of CalPERS land and money into a venture called LandSource Communities, which among other properties included a massive residential development north of Los Angeles called Newhall Ranch. On June 9, creditors of LandSource started bankruptcy proceedings. According to testimony in bankruptcy court, the current owners of the company, which include CalPERS, Cerberus Capital Management, and Lennar (LEN) have asked to buy out the creditors for $750 million. Last year the entire business was valued at $2.6 billion.

The LandSource deal is not CalPERS' and MacFarlane's only real estate headache. The fund is invested in additional residential developments in Los Angeles that are newly built or still under construction. Through MacFarlane, for example, the fund owns half of the Mercury, a 240-unit condominium project that opened a year ago in Los Angeles' Koreatown neighborhood. In March of this year, the other partner, Cleveland developer Forest City Enterprises (FCEB), reported that only 38 percent of the units were sold and that it was taking an $8.2 million loss on its investment so far.

Through a separate but related program called the California Initiative, CalPERS has also invested $1 billion in private equity firms to invest in California businesses. The fund reported earlier this year that these firms are invested in more than 200 companies responsible for over 50,000 jobs. CalPERS says the first $500 million of those funds invested has earned 18 percent a year since 2001. Its real estate investments, both in and outside of California, returned 10 percent for the 12 months ended in February of this year, twice the overall return of the fund. CalPERS says its urban real estate investments have earned it 20 percent per year. There is usually a lag, however, in reporting real estate investment returns because values aren't updated as regularly as stocks and bonds.

A big hit with unions
In any event, CalPERS' exposure to California land is massive. In April, the fund reported it had 25 percent of its $20 billion invested in real estate assets in the state. That's a large position, considering that the fund overall has only 9 percent of its assets in California and the state makes up 12 percent of the U.S. population and 13 percent of the nation's economic output. Most pension funds do not have specific policies that dictate they invest their money in their home state.

Angelides did get one clear return on his initiative: a deluge of campaign contributions from real estate developers and money managers who did business with the state funds. These included $25,000 from MacFarlane and $13,500 from Forest City, the other partner in the Mercury, according to filings at the California Secretary of State's office. Angelides, a Democrat, also scored large contributions from unions, which were big proponents of limiting investments in emerging markets because those countries take U.S. manufacturing jobs.

The CalPERS board has 13 members; CalSTRS has 12. Board members are a mix of gubernatorial appointees, representatives chosen by state employees, and two statewide elected officials —the treasurer and the controller. In response to continuing concerns in the investment industry about "pay to play," the CalSTRS board in October of last year prohibited money managers doing business with the fund from making campaign contributions of more than $1,000 individually or $5,000 per company to the state's governor, treasurer or controller. The current state treasurer, John Lockyer, opposed the restrictions. State Controller John Chiang voted in favor of them.

Angelides has maintained he never allowed campaign contributions to influence his investment decisions.

Where is Angelides today? In February of this year he joined Canyon Capital Realty Advisors, an investment firm that specializes in urban real estate and invests several hundred million dollars on behalf of CalPERS and CalSTRS.